Hydros Experiences with FAS 133 in US GAAP

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Hydros Experiences with FAS 133 in US GAAP

• NAET meeting 29th January 2004

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Hydro and Electricity

• Nordic region
• 8 TWh Hydropower production
• 15 TWh consumption
• Aluminium
• Agri
• Petrochemical
• Europe
• 0,5-1 TWh Industrial production
• 9 TWh consumption
• Agri
• Aluminium

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Hydro and Electricity

• Active trader in all markets where we have
  physical positions
• Balancing responsibility in Nordic countries,
  Germany, France, Netherlands, Belgium and Italy
• Member of NordPool, EEX, APX and PowerNext
• Selling Risk Management Services and Products
• Large Industrial companies
• Medium to Small retailers/ distributors
• Total external customer base represents 20
  TWh/year
• Total Energy supplier
• Oil, NGL, Natural Gas and Electricity

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Agenda

• Introduction
• Best of US GAAP rules
• Hydros experiences
• How does Hydro handle these issues
• Hedge Accounting

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Agenda

• Introduction
• Best of US GAAP rules
• Hydros experiences
• How does Hydro handle these issues
• Hedge Accounting

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Introduction

• Because Hydro is listed on the New York Stock
  Exchange we need to follow US Generally Accepted
  Accounting Principles (GAAP)
• US GAAP has since 2000 had in place regulations
  regarding treatment of derivatives with its own
  definition of what a derivative is
• Once a contract is classified as a derivative it
  has to be accounted Mark-to-Market
• Im not an accountant! So this is a business
  perspective on things

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Agenda

• Introduction
• Best of US GAAP rules
• Hydros experiences
• How does Hydro handle these issues
• Hedge Accounting

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M2M vs. LCM

• Mark-to-Market (M2M)
• A valuation based on the value a certain contract
  would have in the market today, positive or
  negative
• Mark-to-Market Value (Market price Contract
  price) Volume
• Lower of Cost or Market (LCM)
• To ensure prudent accounting, a contract should
  be compared to the lowest of either its cost or
  the market value today
• LCM minM2M-value, Cost-based-value
• In practice You book all negative M2M-values and
  NO positive ones

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US GAAPs rules

• All contracts that are classified as derivatives
  has to be accounted for on a M2M basis all
  other contracts LCM
• The basis for this is that the accounts should
  reflect the solidity/ status of the company
  today
• Example 100 MNOK equity company has bought 10
  TWh of cal 2005 at 230 NOK/MWh. When are they
  bankrupt?
• According to US GAAP as soon as the price for
  2005 falls below 220 NOK/MWh
• According to N GAAP if they lose more than 100
  MNOK in cash (during 2005)

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What is a derivative according to US GAAP

• In principle a generic description, irrespective
  of cosmetic parameters of the contract e.g.
  whether it is physical or financial
• Main principle Is the contract Readily
  Convertible to Cash?
• Several more detailed checks Does it have a
  notional amount? Does it have an underlying? Does
  it require an initial investment? Is it an actual
  or implicit net settlement? Is there a market
  mechanism that allows net settlement? Is it
  readily convertible to cash in other ways?
• Normal Purchase/Sale
• If the contract is a part of your normal
  business, you can exempt it, even if it fulfills
  some of the characteristics of a derivative
• Typically a physical contract delivered to your
  factory

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Accounting principles

• All derivative contracts have to be accounted for
  mark-to-market
• The calculation is done on a contract-by-contract
  basis
• All contracts with positive values are booked as
  assets
• All contracts with negative values are booked as
  liabilities
• Net value booked against the Profit/Loss-statement
  

Liability
Asset
Profit/Loss
Equity
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100 special rules at least

• If a contract has indexation it has an embedded
  derivative and is in itself a derivative
• But if it is signed before 1998 it is OK
• If the contract has a horizon beyond where there
  is a sensible market, the portion of the value
  that goes beyond the sensible market is not taken
  into the accounts
• If the contract contains net settlement clauses
  it can NOT be a normal purchase/sale
• Counterparties where there exists foolproof
  netting agreements (e.g. NordPool) should be
  accounted net, instead of contract-by-contract
• etc

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Agenda

• Introduction
• Best of US GAAP rules
• Hydros experiences
• How does Hydro handle these issues
• Hedge Accounting

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Hydros experiences
3rd quarter results 2003
Annual report 2002
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Hydros experiences - 1

• Business and accounting rules interact
• Example If M2M is not applied to all contracts
  in a balanced portfolio, you get weird effects
• Buy 1000 MWh for 2005 at 230 NOK/MWh, Sell 1000
  MWh for 2005 at 231 NOK/MWh, market now is 215
  NOK/MWh.
• Business logic you made 1000 NOK
• Accounting logic could be Sales contract has no
  notional and as such is not applicable for M2M.
  The M2M value of the purchase contract is -15
  000 NOK. You have lost 15.000 NOK.
• So Trading logic and Business choices can be
  affected by the accounting rules

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Hydros experiences - 2

• This is a LOT of work!
• Operationally
• Producing the numbers often within (very) tight
  deadlines
• Documenting all prices and valuations
• Controlling the numbers
• Posting the numbers
• and Administratively
• Follow up audits and controls
• Document and prove various choices/ decisions
• Not least Follow the changing rules and
  regulations, keeping up to speed, being able to
  discuss with, and challenge, the auditors

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Hydros experiences - 3

• Result volatility is a problem
• We use discounting to take a time reserve
• Interest rate changes gt changing results
• Currency hedges are financial items
• Currency change gt Operating result changes one
  way, financial items another, result before/after
  taxes virtually unchanged
• How do you hedge production?
• Cash or accounting result?!?
• Unbalanced portfolios one side of a balanced
  deal excluded

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Agenda

• Introduction
• Best of US GAAP rules
• Hydros experiences
• How does Hydro handle these issues
• Hedge Accounting

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How does Hydro handle the issue?

• We use the same models that we use for Portfolio
  Management to value our contracts for accounting
  purposes
• The best way to do it if you can pull it off
• Necessary to consistently use Market Prices, and
  NOT forecasts
• Pros
• Consistency
• Possible to check against business
• (Fairly) Automated Process
• Cons
• Models originally tuned towards business needs
• No independent valuations
• More documentation needed towards auditors

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How does Hydro handle the issue?
Same methods varying process
Reporting split in assets and liabilities
Reverse last months posting - post new numbers
Contracts relevant for accounting-mark-to-market
Simulate prices for various markets
Valuation of all contracts individually
Portfolio reporting
Trading strategies
All contracts
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How does Hydro handle the issue?
Same methods varying process
Reporting split in assets and liabilities
Reverse last months posting - post new numbers
Contracts relevant for accounting-mark-to-market
Simulate prices for various markets
Valuation of all contracts individually
Portfolio reporting
Trading strategies
All contracts
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Agenda

• Introduction
• Best of US GAAP rules
• Hydros experiences
• How does Hydro handle these issues
• Hedge Accounting

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Hedge accounting

• Accounting-wise more complex.
• But the principle remains
• All contracts that can be classified as
  derivatives has to be accounted for
  Mark-to-Market
• All contracts with positive M2M-values booked as
  assets
• All contracts with negative M2M-values booked as
  liabilities
• With a small, but important variation The net
  value of all contracts is booked directly against
  the equity, and NOT through the P/L

Asset
Equity
Current liabil.
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Hydros view on Hedge Accounting

• We dont do it yet
• Because
• Equity movements without Profit/Loss elements are
  not something investors enjoy
• The documentation demands is not necessarily
  justified by the benefits of hedge accounting
• If the hedge goes from being effective enough to
  being non-effective, the whole (accumulated)
  effect hits the P/L
• So the description will be more theoretical
  from here on

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Hedge accounting prerequisites

• Need to define a clear asset/contract/something
  to hedge
• The designated hedge has to be effective
• Effective means that the value variations of the
  hedge has to be within a band of 80 to 120
  (under US GAAP) of the asset/contract that is
  hedged
• Extensive documentation of the hedges efficiency
  and the contracts included in the hedge

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What to use hedge accounting for

• Dedicated, specific deals with clear boundaries
• Ideally also for physical assets, but that is
  more complicated
• Remove unbalances between sales and purchases
  that give major result variations
• A limited portion of the total value/volume of
  your business
• If your equity moves all over the place you will
  have some serious explaining to do

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What NOT to use hedge accounting for

• Solve the problem as such
• It does not work
• Dynamic hedging of production
• Each hedge is what is designated not the
  hedgable asset/contract
• Your whole business

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Summing up

• These US GAAP principles changed the way we did
  accounting -and it is not going to go away!

Balance sheet profit/loss effects
Mark-to-Market values
LCM
Hedge Acc.
Bal. Sheet eff.
Norm. purch/sale
No effects